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Guilty by Association? Regulating Credit Default Swaps

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Guilty by Association? Regulating Credit Default Swaps GUILTY BY ASSOCIATION? REGULATING CREDIT DEFAULT SWAPS HOUMAN B. SHADAB Abstract A wide range of U.S. policymakers initiated a series of actions in 2008 and 2009 to bring greater regulation and oversight to credit default swaps (CDSs) and other over-the-counter derivatives. The policymakers' stated motivations echoed widely expressed criticisms of the regulation, characteristics, and practices of the CDS market, and focused on the risks of the instruments and the lack of public transparency over their utilization and execution. Certainly, the misuse of certain CDSs enabled mortgage- related security risk to become overconcentrated in some financial institutions. Yet as the analysis in this Article suggests, failing to distinguish between CDS derivatives and the actual mortgage-related debt securities, entities, and practices at the root of the financial crisis may hold CDSs guilty by association. Although structured debt securities and CDSs share some similarities and were often utilized together in synthetic securitizations, the financial instruments are highly distinct and underwriters of such securities make decisions under a very different legal and economic framework than those made by CDS dealers. Unmanageable losses from CDS exposures were largely symptomatic of underlying deficiencies in mortgage-related structured finance and do not primarily reflect fundamental weaknesses in the risk management and infrastructure of the CDS market. In addition, the development of CDSs referencing mortgage-related securities was more of an effect than a cause of the rapid growth in mortgage-related securitization. * Associate Professor of Law, New York Law School. B.A. 1998, University of California at Berkeley; J.D. 2002, University of Southern California. I would like to thank for comments Jerry Ellig and participants at the symposium "The Credit Crash of 2008: Regulation within Economic Crisis" sponsored by the EntrepreneurialBusiness Law Journalof the Ohio State University Moritz College of Law held on March 6, 2009, and Katelyn E. Christ and Charles Post for their invaluable research assistance and editing. All errors are my own. This article originally appeared in the Working Paper Series of the Mercatus Center at George Mason University. 408 ENTREPRENEURIAL BUSINESS LAW [Vol. 4:2 JOURNAL Exemptions by the Securities and Exchange Commission to facilitate the central clearing and exchange trading of CDSs seem desirable, although a significant portion of CDS transactions are unlikely to be improved by utilizing such venues. However, mandatory central clearing is likely unnecessary to reduce CDS counterparty risk and may, in fact, increase counterparty risk to the extent CDS clearinghouses unduly concentrate risk or undermine bilateral risk management. Counterparty risk management in the CDS market has generally been prudent, and systemically troubling CDS transactions arose only from a small portion of the market where financial guarantors sold CDS protection to banks on their mortgage-related debt securities. The role of CDSs in facilitating price discovery also suggests that prohibiting uncovered (naked) CDSs to prevent speculation will decrease transparency in the credit markets. The systemically troublesome CDSs sold by AIG and certain bond insurers were purchased by banks on their mortgage-related securities and not for speculation. Ongoing reforms being undertaken by CDS market participants under the supervision of the Federal Reserve Bank of New York to achieve greater transparency and stability call into question the extent to which additional regulation is necessary. Policymakers should act to prevent the concentration of CDS risk in regulated institutions, particularly when CDSs are sold by insurance companies, purchased by banking institutions, or likewise utilized by such institutions' unregulated subsidiaries. However, increasing regulation of all CDS transactions or all users of CDSs does not seem warranted. 2010] Guilty by Association: 409 Regulating CreditDefault Swaps TABLE OF CONTENTS I. INTRODUCTION ........................................................ 410 II. CDS REGULATION AND REFORM ..................... 419 A. Federal Regulation and Oversight of CDSs 420 B. Contract Law: ISDA Provisions and Auction Protocols 422 C. Treasury Department OTC Derivatives Reform Proposals 424 D. Proposed Legislation Relating to CDSs 425 E. SEC Exemptions to Enable CDS Central Counterparties 426 F. SEC Exemptions to Enable Exchange-Traded CDSs 428 G. State Insurance Law Reform 429 Il. ASSESSMENT OF CDS REFORM ACTIONS AND PROPOSALS .............................. 430 A. CDS Market Characteristics and Practices 430 1. M echanics and Contract Typology ......................................................... 431 2. M arket Size and Users ............................................................................ 432 3. M arket Infrastructure.............................................................................. 435 B. CDSs and the Financial Crisis 441 1. The Growth of Mortgage-RelatedSecurities .......................................... 441 2. Overconcentrationof CDS Exposure: Monoline Bond Insurers............. 444 3. Overconcentrationof CDS Exposure: AIG ............................................. 447 C. CDS Trade and Post-Trade Regulation 452 1. Mandatory Central Clearingand Non-Cleared CDS Requirements........ 452 2. Exchange-TradedCDSs ........................................................................... 456 D. Uncovered CDSs and Price Discovery 457 IV. CONCLUSION .......................................................... 462 410 ENTREPRENEURIAL BUSINESS LA W [Vol. 4:2 JOURNAL I. INTRODUCTION The 2008 financial crisis and ensuing economic downturn led a wide range of U.S. policymakers to undertake actions intended to remedy deficiencies in the regulatory framework applicable to over-the-counter (OTC) derivatives markets. This Article examines policymaking actions intended to reduce the systemic risks posed by credit default swaps (CDSs) in particular and offers a general assessment of the extent to which they are justified in light of the characteristics and dynamics of the CDS market and their role in the financial crisis. A CDS is a type of OTC, or non-exchange traded, derivatives contract that obligates a protection buyer to pay a periodic fee to a protection seller. In return, the protection seller must compensate the buyer if a reference debt obligation experiences a negative credit event, such as a default on a loan. A CDS does not require the protection buyer to actually own or otherwise be exposed to the risk of the reference obligation and hence allows parties to trade (or speculate on) the credit risk of debt obligations such as bonds. As part of a comprehensive plan for financial regulatory reform, on June 17, 2009, the U.S. Department of the Treasury (Treasury Department) proposed fundamental changes to the way all OTC derivatives are regulated, including CDSs. The Treasury Department's proposal seeks mandatory central clearing or exchange trading of standardized CDS contracts, prudential bank-like regulation of major CDS market participants, and enhanced transparency and recordkeeping requirements for all CDS transactions.' Several bills introduced by congressional lawmakers in 2009 sought to enact reforms similar to those proposed by the Treasury Department. The Securities and Exchange Commission (SEC) also promulgated a series of exemptions to facilitate the central clearing of CDSs by approving the applications of private entities to engage in central clearing without being subject to the full scope of SEC regulation applicable to clearinghouses. These and other policymaking initiatives are further detailed in Section II. The policymakers' stated motivations echoed widely expressed criticism of the regulation, characteristics, and practices of CDS market participants, the risks of the instruments to the financial system as a whole, and the lack of public transparency over CDS utilization and execution. 2 ' DEP'T OF THE TREASURY, FINANCIAL REGULATORY REFORM: A NEW FOUNDATION, 48 (Updated July 24, 2009), http://www.fmancialstability.gov/docs/regs/FinalReport web.pdf. 2 Other official bodies have also weighed in on issues surrounding CDSs. In January of 2009, a U.S. Congressional Oversight Panel and the Group of Thirty each issued reports critical of the regulatory framework applicable to CDSs and their role in the financial crisis and urged similar reforms. CONG. OVERSIGHT 2010] Guilty by Association: 411 Regulating Credit Default Swaps Particularly concerning to policymakers was that CDS protection sellers were not required by law to set aside capital to meet their obligations, and that regulators and market participants were seemingly unaware of the risks that particular institutions had accumulated through their CDS exposures. 3 These concerns are not without merit. CDSs were, in a sense, born in regulatory sin: they were first used by commercial banks in the late 1990s in part to decrease the amount of capital that regulation required banks to hold in reserve. 4 CDSs also helped to facilitate the growth of mortgage-related securitization by providing banks with protection from the risks involved with securitization. 5 In addition, CDSs enabled the creation of mortgage-related securities by allowing for the creation of synthetic collateralized debt obligations (CDOs). 6 A CDO is a type of asset-backed debt security that up through the crisis became increasingly backed by cash flows from
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